Events in Egypt have created a cautious trading mood this Monday morning. Images broadcasted from Egypt over the last few days have had markets contemplating further contagion in the region. In particular, fears that transit through the Suez Canal might be disrupted have filtered though into oil prices, pushing WTI crude down nearly 4% on Friday. In a relatively anticipated move, Moody's downgraded Egypt's sovereign debt to Ba2 from BA1; outlook negative. Regional equity markets fell across the board on Sunday which put pressure on Asian indexes. USDJPY declined steadily to 81.92 as traders moved back into safe-havens (although flows have been light). Although Egypt has the largest population in the Middle East and is a critical barometer of social and political sentiment, we are unconvinced that the domestic situation will migrate to other regional nations. It is important to highlight that the movement of capital is more about risk reduction then panic flows which hint to us that a reversal should be expected. Reaction in the FX markets to the Egypt situation has been subdued overall. While the situation in Egypt remains tense, cloudy and fluid (one million people expected to protest tomorrow) we suspect that this week's data laden calendar will quickly shift focus toward incoming economic data. Today's euro area inflation numbers will be important to traders tracking the evolving ECB monetary policy story. CPI is expected to increase m/m to 2.3% vs. 2.2% prior, slightly above the ECB 2.0% target's upper band. It was only three weeks ago at the last ECB meeting where Trichet kicked off the debate on earlier-than-expected tightening with his surprisingly hawkish comments. EU / US interest differentials have slowly widened as risks of a sovereign crisis have decreased and expectations for interest rate hikes has increased, giving the EURUSD much needed support. We suspect that the inflation data from Europe will print to the upside which should be sufficient to push EURUSD back to the 1.3700 level, despite weak risk appetite. Perhaps the currencies most exposed to a drawn-out event risk from the Middle East are Asian currencies (USDSGD traded to a high of 1.2884 while there was plenty of market chatter of official USD buying in Taiwan in today's session). Inflation is already a major concern to the region (key CPI to be released this week) and a major supply shock in oil prices will amplify pressures while decreasing demand for exports. With China tightening policy the AUD potentially stands most exposed - still reeling from flood damage, and the RBA less keen on near term hikes. Speaking of Australia, we suspect that the RBA will keep rates on hold at 4.75% yet sound hawkish in its communiqué. Although the anti-inflation rhetoric remains high the bills markets has shifted expectations of further increases back until Q3 this year. In addition, data this week (trade data) will have likely been influenced by the Queensland floods which will add to the negative sentiment surround the AUD.
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